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Scrapped IPO, $16B Archstone Sale Underscores Market Twists and Turns For Apartment Investors

Though Some Are Concerned The Window For Multifamily Investment Is Starting to Close, Analysts Give (Mostly) A Thumbs Up to Huge Apt Transaction
November 28, 2012
Even as Archstone was filing its latest plans last week with the SEC for what would have been the largest real estate IPO in history, its owner, bankrupt investment banking firm Lehman Brothers Holdings Inc., was quietly negotiating the apartment giant's sale to two of the nation’s largest multifamily REITs.

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In a post-Thanksgiving surprise this week, Equity Residential (NYSE: EQR) and AvalonBay Communities, Inc. (NYSE: AVB) agreed to buy Archstone Enterprise LP from Lehman in a blockbuster deal consisting of $6.5 billion in cash and stock and $9.5 billion in assumed debt.

EQR will acquire about 60% of Archstone’s assets and debt while AvalonBay will get 40% of the Englewood, CO-based apartment company, Lehman's largest asset. The transaction is scheduled to close in the first quarter of 2013.

Just last week, Archstone updated its IPO plans, announcing it would raise $3.45 billion. The industry buzzed for months about whether the offering would help jumpstart the lukewarm IPO market for commercial real estate, only to see Chicago-based Equity Residential, headed by legendary CRE dealmaker Sam Zell, return in dramatic fashion after failing to wrestle control of Archstone away from Lehman in bankruptcy court proceedings.

After the initial surprise of the announcement saw both AvalonBay and Equity Residential share prices dip on Monday, analysts and investors have since largely accepted Archstone’s re-entry into the public market through acquisition rather than IPO as positive for the companies and for the apartment REIT sector.

The acquisition is likely to result in benefits of scale, operational efficiencies and geographic reach, improving the overall quality and diversity of both companies’ portfolios with assets in high-barrier, high-growth coastal markets, analysts said.

AvalonBay, with its purchase of $6.7 billion in Archstone assets and debt, lifts its total market cap by 40% to over $23 billion. The move will boost its holdings in Southern California -- long a goal of AVB management -- and diversify its rental price points in core markets while lowering its average revenue per occupied unit. "Avalon is clearly more focused on trying to find the best submarkets, product and growth opportunities," according to Michael Bilerman, REIT analyst for Citi.

For Equity Residential, the Archstone purchase is the most dramatic move in a decade-long process of refining and expanding its portfolio, Bilerman said. EQR will acquire 78 apartment properties totaling 23,110 units, increasing its presence in the eastern U.S. and lifting its average portfolio rents by about 8% to $1,810 per unit, and increasing its holdings in Washington, D.C., New York City, San Francisco and Boston.

The deal also provides a path for external growth at a time when apartment development is ramping up (See related CoStar story). EQR’s portion of the deal includes four new developments under construction and 15 land parcels.

According to analysts, Lehman’s decision to accept the buyout rather than pursue an IPO appears to be the safest and most efficient course for all parties in a publicly traded apartment REIT market that has slowed over the last year. As a public company, Archstone would have been under pressure to monetize its holdings to pay off Lehman's shareholders more quickly, and the new REIT would have been saddled with a high debt ratio relative to other apartment REITs.

By taking the offer, Lehman will hold a 13.2% minority share in AVB and 9.8% in EQR, two established and well-capitalized public companies.

"While we had no doubt in Archstone's ability to complete an IPO in the current environment, we believe the Lehman Estate decided to go with the certainty of an EQR/AVB deal, versus taking the market risk of going public in hopes of a better exit," said Alexander Goldfarb and James Milam, apartment REIT analysts for Sandler O'Neill, in a note to investors.

As a result of the acquisition, EQR’s assumed and existing debt will be dilutive to the company’s balance sheet, requiring it to raise cash through $3 billion to $4 billion in planned sales of apartments in Atlanta, Jacksonville, Orlando, FL, and Phoenix, among other markets.

While selling the assets reduce its debt and strengthen its credit shouldn’t be a problem, failure to do so in in a timely way could result in a downgrade of Equity Residential, Standard & Poor's Ratings Services said Tuesday.

S&P emphasized that its rating and outlook for EQR are unchanged despite the higher initial leverage linked to its assumption of $5.5 billion of Archstone debt, which will shrink after Archstone sells roughly $750 million of assets that EQR is under contract to acquire -- if the sale goes through without delay.

"In the current favorable environment for multifamily assets, we believe the company will be able to execute on its planned equity sale and asset dispositions such that leverage and credit metrics will return to pre-transaction levels by the end of 2013," S&P said. "We view the transaction as strategically positive for the business because it accelerates the company's portfolio-repositioning plan and [we] believe there is limited integration risk."

Fitch Ratings, however, put EQR's on watch for possible downgrade as a result of the added debt.

EQR and AVB are raising $3.25 billion of equity and Lehman will end up with $3.8 billion in AvalonBay and Equity Residential stock as well as $2.7 billion in cash.

"The deal appears to maximize present value and minimize execution risk for Lehman, and provides benefits to EQR and AVB. Overall, we are positive on the transaction for both EQR and AVB, as it improves portfolio quality, diversifies market exposure, accomplishes strategic objectives and allows each to more efficiently leverage their scale," S&P said.

By unloading at least $3-$4 billion of assets in noncore markets, primarily through 1031 exchanges over the next 12 months, EQR plans to repay the assumed Archstone debt and pay down its own debt, including more than $400 million of Fannie Mae and Freddie Mac agency debt at the transaction closing. Another $1.2 billion and $880 million of GSE debt is pre-payable in 2013 and 2014, respectively.

Bilerman said the price Lehman will receive for Archstone confirms that it made a sound decision to sell after acquiring minority interests from Bank of America and Barclays earlier this year to fend off a takeover by EQR. Lehman at that time paid $2.975 billion for 53.6% of Archstone, implying a total value of just over $5.5 billion, which would leave Lehman with a $1 billion profit.

Thus, the $6.5 billion Lehman is receiving under the current agreement -- though apparently down somewhat from the original deal valuation of $6.75 billion due to declines in both companies’ stock over the last month -- “looks to be a win for the Lehman estate," Bilerman said.

If the deal doesn't go through, AvalonBay and EQR would have to pay Lehman a $650 million breakup fee, which jumps to $800 million if closing is delayed beyond 60 days.
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